APRA reaffirms revised mortgage risk weight target

The Australian Prudential Regulation Authority (APRA) has today reaffirmed its objective, announced in 2015, to raise Australian residential mortgage risk weights applied by banks using internal models to an average of at least 25 per cent.

In July 2015 APRA announced changes to the treatment of residential mortgages for banks able to use internal models for capital adequacy purposes. In particular, APRA adjusted the risk weight calculation used by authorised deposit-taking institutions (ADIs) accredited to use the internal ratings-based (IRB) approach to credit risk. The adjustment was intended to increase the average risk weight on Australian residential mortgage exposures, measured across all IRB ADIs, from approximately 16 per cent to an average of at least 25 per cent. The increase in IRB risk weights came into effect from 1 July 2016.

Subsequent to the announcement in July 2015, APRA has also required IRB ADIs to make a range of other changes to their models as part of its routine supervisory processes, with a view to improving their comparability, reliability and risk sensitivity. The impact of these modelling changes, when combined with the adjustment proposed in July 2015, would have been an average risk weight that was well in excess of the 25 per cent risk weight targeted by APRA in its original announcement.

APRA has therefore advised the relevant ADIs that it will recalibrate the adjustment advised in July 2015, with a view to ensuring the original target of an average risk weight for Australian residential mortgages of at least 25 per cent is achieved, while not significantly exceeding this target. In doing so, APRA has taken into account modelling changes that have been instituted, as well as some that are to be completed over the coming quarters; in some cases, this recalibration is conditional on the ADIs completing (offsetting) modelling improvements.

This adjustment to mortgage risk weights remains an interim measure, pending the outcome of the deliberations of the Basel Committee on Banking Supervision (Basel Committee) to finalise reforms to the capital adequacy framework, and APRA’s subsequent consideration of how those reforms should be applied in Australia. In the meantime, APRA continues to target an average residential mortgage risk weight for IRB banks of at least 25 per cent. As modelling changes work through the system, APRA expects the average across all IRB banks will vary somewhat over time, but still be consistent with the objective of achieving an average risk weight of at least 25 per cent.

Background

Q: Why did APRA increase residential mortgage risk weights for IRB ADIs from July 2016?

A: The increase in IRB mortgage risk weights:

• addresses a recommendation of the Financial System Inquiry (FSI) that APRA narrow the difference between average mortgage risk weights for ADIs using IRB risk weight models and those using standardised risk weights (Recommendation 2);

• aligns with the direction of work being undertaken by the Basel Committee; and

• will have the effect of enhancing the resilience of IRB ADIs and the broader financial system.

Q: Which ADIs are accredited to use the IRB approach to credit risk?

A: The ADIs accredited to use the IRB approach are: Australia and New Zealand Banking Group, Commonwealth Bank of Australia, Macquarie Bank, National Australia Bank and Westpac Banking Corporation.

Q: Given APRA announced increased IRB residential mortgage risk weights in 2015, why is this announcement necessary?

A: IRB models require ongoing maintenance by ADIs, and supervision by APRA, to ensure the models remain fit for purpose. A range of changes to ADIs’ models have occurred over the past year, the impact of which – when combined with the adjustment APRA made in July 2015 – would have been to produce an average risk weight well in excess of the 25 per cent average that APRA was targeting. APRA has therefore recently advised the affected banks that it has recalibrated the adjustment originally advised to banks. In doing so, APRA wishes to confirm that its original objective of achieving an average risk weight for Australian residential mortgages of at least 25 per cent remains unchanged.

Q: Does this mean 25 per cent is now the minimum risk weight on all residential mortgages?

A: No. Consistent with the FSI’s recommendation, APRA is targeting an average IRB risk weight for residential mortgage exposures, measured across all IRB banks, of at least 25 per cent. IRB ADIs will continue to have a range of risk weights for individual mortgage exposures and portfolio segments.

Q: Does the change affect lending to small business secured by residential mortgages?

A: No. APRA announced in July 2015 that ‘the increased IRB risk weights applies to all Australian residential mortgages, other than lending to small businesses secured by residential mortgages.’ That continues to be the case.

Q: Is APRA also changing mortgage risk weights for the non-IRB ADIs?

A: The increase in mortgage risk weights announced in July 2015 and reaffirmed today affects IRB ADIs only. No changes have been made to the capital requirements for ADIs using the standardised approach (non-IRB ADIs).